While I was on the road the past week, I had the opportunity to see Lawrewnce (Larry) McDonald give a talk about his book, and offer his perspective of our economic and political landscape.
But before I delve into his talk, and our dinner afterward, there are two points I want to make: first, Larry is a good speaker on these issues. He understands how to break down market complexities and does a good job of making things easier to understand. Second, call this the power of Twitter in action. I started following Larry on Twitter not long before his book was published. I’m just a fan of what he’s doing – trying to speak to people about what happened at Lehman, and offer up ideas about what we need to do to fix things going forward. Because beyond the soundbites, the partisan bickering, and the hype, there’s a story entwined in all of this as old as time and we need to revisit that story to learn from it.
After he gave his talk and signed copies of his book on a cold Wednesday night in January in Midtown Manhattan, Larry, James (his agent), and I had dinner at Oceana restaurant. It was a great time, truly memorable and enjoyable. And so for those of you that follow my blog (yes, the 2 of you), I put down some of the deeper thoughts we had while we ate our food, drank our drinks, and tried to solve the world’s problems – not necessarily in that order, though.
In our minds there seem to be two distinct – but unrelated – bubbles: China and the number of bloggers.
There is considerable debate about whether China is in a bubble or not, but when you take a look at the policies China is following – from importing excessively easy monetary policy from the US via its currency peg to fiscal stimulus that leads directly to increases in production capacity by funding construction of factories, power plants and other infrastructure – it’s hard to argue against the idea the Chinese are in a bubble. But it’s not a typical bubble, which relates to asset prices.
It’s in terms of production capacity. The Chinese are expanding production capacity that probably assumes the world’s GDP will grow 5-8% per year. The question is what happens if it only grows 2-4% per year, which seems likely? That means you have a bubble of excess capacity. Which means lower prices for everything over time. The only thing that would stop that? An increasing birth rate. But that would still take several years to work because it’s not like babies go to work and buy stuff as soon as they are born. Plus, there’s excess credit flowing through the the country which means the necessary conditions for the formation of a bubble are there.
As for bloggers, they seem to be everywhere (hand raised). With the internet and the democratization of data/information, the cost of producing content is virtually nothing. It’s a key reason why print media is struggling so mightily these days: the advantage they had (information) has been digitized away and the legacy costs of print media make little to no sense in such an environment.
But can it last? That remains to be seen. Larry talked about the idea of mean reversion in bloggers and content, which made sense to me. Mean reversion is based on the premise that growth rates/yields revert back to their long-term averages over time, hence the name of the concept. James talked about a similar idea, but in a different context: the idea that print will be fashionable again. Because there’s something comforting about actually sitting down with a book or newspaper than just viewing it on a screen. And on that note, the 2 followers of this blog probably went out to buy books and I’ll probably never hear from them again.
On Models and Modeling Credit Risk
I spend a lot of time on this blog talking about credit risk and almost as much time talking about models and math. Neither one of us believe a model is going to be the end-all/be-all in terms of capturing risk: there are too many things going on in the world at one time, and the equations only capture so many of those factors. But as I heard someone say at a conference once: “No model is perfect, but some models are useful.” That quote has always stuck with me and I like the premise behind it. No one model will solve for all of the unknowns, but we can look at specific factors through the lens of a model or several models and learn more about it.
One of the problems leading up to the credit crunch was that some people overestimated or oversold the benefits and uses of models. I know some of this was done to convince people to adapt their usage, but to my way of thinking, the emphasis on kaizen would have been much more appropriate. In the kaizen framework, the emphasis is on continuous, incremental improvement, not believing some silver bullet or panacea was coming along to solve the problem. I think there was too much emphasis on a quick solution and nobody thought these models needed to be back tested, re-estimated, or possibly re-developed as much as they probably need to. But on the other hand, if models weren’t being offered as a pancea, adoption may not have been as prevalent, forcing people to rely more on judgment. Whether that would have been good or bad is something we’ll never know.
Also, a lot of models were developed while Greenspan was still Fed chair, and as chief nanny of the credit markets, he set a tone for market behavior that is most likely captured somehow in the models that were developed then, and shows itself in model results.
But when the credit crunch began in earnest, the macro environment changed and as such, the data probably started showing signs of having undergone a change in regime, most likely characterized by higher volatilities and other phenomena that didn’t exist before. As such, the models that worked before probably won’t work going forward. So a lot of work that has been done will have to be scrapped, but the models that will result from those re-designs should be much more robust than the models heading into the crisis. So color me optimistic on this front.
On Future Crises
This was a very interesting – and harrowing – topic. A lot of this topic we owe to Ashish Shah, a key figure in Larry’s book, who was at the restaurant at the time. We were thrilled he stopped by and talked with us. A true delight even if the subject was not the most uplifting one to discuss.
We talked about the nature of economic and market crises we’ve seen over the past 15 years and when you step back and look at them in total, there are two things that stand out: the costs associated with fixing them and the timing in between each one. We had the banking/S&L crisis in the early 90’s which coincided with the beginning of Japan’s Lost Decades. After that, there was the Tequila Crisis with Mexico/Latin America, Asian Debt Crisis, the Russian defaults & LTCM, the .com deflation, the housing bubble and bust, and now elevated sovereign risks. Each problem has cost more and more to resolve, while the time interval between each crisis get shorter. You can probably make the case the .com bubble was a phenomena unto its own (it’s the one bubble that did not involve the use of debt; it was an equity bubble), but each one has cost more to clean up because of two things: 1) the sizes of the firms involved has gotten bigger and 2) as those firms have gotten bigger, the number of market participants has fallen.
There’s real concentration risk amongst counterparties these days. Would re-instituting Glass-Steagall help solve this issue? Larry thinks so, but I’m not as convinced that that’s the remedy we need. We need to firewall custodial/fiduciary assets from assets and liabilities used in the ongoing financing of these firms, for sure. Counterparty risks need to be addressed with better mark-to-market/margining practices (smaller moves in asset prices, more frequent margining/collateral calls) which are strictly enforced. The requirements to trade in these instruments need to be changed, so that you don’t have 90% of the contracts being controlled by 15-20 firms. I don’t see these items as all-or-nothing proposals, but as areas where reasonable people can disagree and where we can work together to investigate the issues and make our best effort to solve them.
Because as grown-ups, that’s what we have to do. We have to because these are burdens none of us want to leave for future generations. We owe it to them to understand these things, fix them, and pass along what we’ve learned.
On Lehman and its Collapse
And then, we went back to the scene of the crime: Lehman and its demise. Was the bankruptcy a mistake? Maybe, maybe not. There are plenty of people that are still angry over the bankruptcy; people who had Lehman bonds as investments, people that worked in the unglamorous middle and back office of the company, all of them still mad that things got that point. But as Larry and I talked about it, I think two things became clear: first, the take-under of Bear Stearns was a mistake. That deal to hand over Bear to JPMC and the conservatorships of Fannie and Freddie set up the next company to fail, regardless of who it was. It was a race to see if that next company to fail was going to be Lehman or if it was going to be Merrill Lynch. Second, there was no way we were going to avoid this. With so much in illiquid instruments around (I choose not to call them an asset or liability because those labels are two sides of the same coin; it just depends on which half of the balance sheet you book them on) and everyone wanting to dump them en masse for cash, there was no way we were going to come through this without some casualties. And some of them were going to be big ones. The values those instruments were marked at were going to have to come down as real estate values came down, because so many of them were tied to the real estate market and the excessive levels of liquidity in the market we saw.
There was other stuff we talked about as well. From my son who has read Larry’s book three times (at the age of 9), to the joys and simplicities of cooking (most of the time the problem is not the food – it is us), to declaring the death of Gordon Ramsay as media and restaurant mogul (official time of death: 9:15PM 1/13/10 – we called it), there was plenty to talk about.
I’m sure this won’t be the last time we do this, because it was just too enjoyable not to do again.I just hope the next time we get together the weather is warmer, like the friendship and the food were. Maybe we’ll have another friend join us and maybe we’ll get to the bottom of some of these issues next time, and how to fix them.
But if you get the chance to see and hear Larry as he speaks on Lehman, go see him. He has a great story to tell and he’s a good storyteller.